What to Do When Inflation Comes Knocking

From the local coffee shop to the Federal Reserve, its post-recession comeback has been much feared. Anyone who lived through the astronomical price jumps of the 1970s will likely tell you those concerns are well-founded.

Inflation is knocking, but there are strategies that can hedge against rising costs and possibly even prove profitable.

Like trying to push back a waterfall, it won't be held at bay forever. Already, inflation is making itself felt, creeping back into the economy even as consumers shell out more for gas and groceries.

With, at the very least, modest inflation predictably on the horizon, retirees and pre-retirees typically have the most at stake. The former, living on fixed income, can ill afford more out-of-pocket costs for food, clothing and health care (including cost sharing in employer plans and Medicare Part B premiums). The latter, in a to-the-wire push to accumulate assets, may not relish the idea of their game plan being upset.

Is there a way to make inflation work to your benefit? Are there financial strategies that can not only hedge against rising costs but even prove profitable?

The good news is that inflation will possibly boost the value of your home, at least stanching the steady bleed of equity over the past few years.

There are also specific tools for the job at hand. You can buy Treasury Inflation Protected Securities, better known as TIPS, directly from the Treasury Department. Various mutual funds, such as the Vanguard Inflation-Protected Securities Fund ( VIPSX), offer another way to easily incorporate these instruments to your portfolio.

To tackle inflation, one should understand the enemy.

Inflation will likely trigger the chain of events that leads the Fed to drive up interest rates. Surveys have shown that many passive investors fail to realize the damage that can hit their bond holdings when this happens.

Investors need "a clear understanding of the relationship between asset returns and inflation," a recent report from Vanguard suggests. "For those with long-term investment horizons, risky assets like stocks and bonds may earn returns high enough to overcome erosion in purchasing power due to inflation, on average. However, investors looking to hedge against inflation are typically concerned with short- and medium-term protection."

Investors should be aware of the difference between expected and unexpected inflation. Expected inflation is the market's consensus view on the future path of inflation.

"Because financial markets are forward-looking, they presumably incorporate this view into current asset prices," Vanguard says. "'Inflation risk' is generally a worry about unexpected inflation."

Among the assets with returns that have historically risen with inflation are commodity futures. Treasury bills have tended to do better amid expected inflation.

Stuart Ritter, a financial planner in T. Rowe Price's ( TROW) Financial Planning Services Group and a vice president of T. Rowe Price Investment Services, stresses a portfolio that is diversified with inflation risk in mind.

"There should be an understanding that it's out there, that 'inflation is one of the many risks I face,' and 'I've designed my portfolio between my exposure to inflation risk and my exposure to short-term volatility risk.' What's important is that you have constructed a portfolio that is appropriate for your time horizon. If it's a long time horizon, and inflation is my biggest risk, I've got much of my money in equities so that I've minimized that inflation risk. If it's a short time horizon, where inflation isn't going to make the price of what I buy go up that much, then I'm mostly in stable assets because I don't want to take on the volatility and risk," Ritter says.

"Be opportunistic when the opportunity presents itself and be defensive when you need to," he says. "For example, earlier in the year we saw an attractive opportunity to get into municipal bonds, even though a lot of people were saying bonds are exactly the place not to be if you are expecting inflation. But if you are active you can take advantage of assets, including bonds, that have been beat up or are below the average price. As long as you keep track of these things, you can be ready to sell once it gets to a situation where they reached your price target."

Conversely, he's not all that sold on the prospects of TIPS and Treasuries.

"A lot of people talk about TIPS as being a good inflation hedge," he says. "But, currently, we don't believe it is because it has already been bid up because so many people have expected, and talked about, inflation in the last few years. Now it is no longer so attractive, so we're out of there."

When turning to stocks, Freyre advises "being careful not to be overloaded in areas of equities that tend to go down with interest rates, like financial or utilities."

For people who are aggressive, such as investors who are tactical traders, it could be a strategy to go inverse or short on some of those asset classes or investments expected to go down as inflation picks up.

"The problem with that is you have to get a lot of things right, and the odds are against you," Freyre says. "Most pre-retirees and retirees are probably on the buy-and-hold side of things, so I would caution those investors against trying this. But for those looking to profit from inflation, there are aggressive strategies out there -- but they come with aggressive risk."

Commodity speculation, as expected, is a popular approach.

"Real assets and hard assets are things that tend to be driven by inflation, so it will benefit you," Freyre says.

He cautions, however, that not all investment tools are created equal.

"When it comes to commodities, when you are trying to hedge against inflation, there is one specific element you have to be aware of with ETFs," he says. "That's the mispricing when it's dealing with future contracts on the commodities. One example of that was last year, when natural gas prices went up, yet ETFs that track gas went down. You have to be careful -- not everything in ETFs operate the way you would think they would when you are dealing with the underlying investment in futures contracts. Just because the name says grains, you are not necessarily investing in something directly correlated to that asset."

As for gold, the most buzz-worthy hedging strategy out there, Freyre fears it "has gone up so much that there is probably more risk it coming down than there is of it continuing in its current direction, even with inflation."

"Gold has historically done well in inflation, but you are paying a premium for it right now, so the risk of you being right on that transaction diminishes," he says. "You may be better off waiting for it to come down and then getting in."